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Jun 11 Consensus Without Trust

A specter is haunting global capitalism: the specter of cryptocurrencies. Three distinct forces of our modern age have come together to breathe life into this strange and wondrous monetary artifice. One, the rise of computational power that allows algorithms to programmatically issue currencies; two, distrust towards governments who can idiosyncratically debase currency or even demonetize at will; and three scarcity of safe assets to store wealth over the long term. The birth of the first cryptocurrency — bitcoin — was announced to the world in 1998 by a still unidentified inventor(s) who goes by the name ‘Satoshi Nakamoto’. [note: small ‘b’ bitcoin is the currency, capital ‘B’ Bitcoin is the network]

If you have never heard of bitcoin or cryptocurrencies, one way to think of it as tokens sold by temples — for special rituals or prasadam — in exchange for cash. These temple tokens, typically, can only be used within the premises. They are often exchangeable between individuals without the permission of any supervening authority. And if you lose the token or forget to use it, it is as good as losing money. This analogy is useful, but it can only go so far. Unlike tokens in a temple which are controlled by authorities, cryptocurrencies are generated by a network of computers that run a software called ‘blockchain’.

Most networks, be it a business or a family, operate by consensus. Every time a new piece of information arrives into this network, the network participants verify its validity using past evidence and a verification mechanism. Then, collectively, if this information is validated to an agreeable degree, a a new modified consensus is arrived at. Implicit in this elementary schemata of generating public knowledge is the assumption that individuals in the network trust each other. What happens if there is no trust? Can families lacking trust arrive at a consensus?

A network that uses ‘blockchain’ transcends this requirement of trust among members to form consensus. It is does this by relying on two fundamental ideas: the near-impossibility of reverse engineering a mathematical algorithm (‘SHA-256 hash function’) and human self-interest. In a blockchain (think of units of information arranged as separate blocks which are concatenated to form a chain), when a new piece of information arrives, it is appended to a previous block to create a new block. This new block is arranged in a specific architecture (‘the Merkle tree’) and the “header” of this new block is passed through the hash function. This function spits out transformed output. We check if this output has specific preset properties. If not, then the block header is incremented by a random number (“nonce”) and this new set is passed through the hash function again.

Finally, after many trials, when we find the appropriate nonce, the ‘miner’ announces this random number to the rest of his peers in the Bitcoin network. They check using this nonce if adding this information produces an output with specific properties including an untampered old block. If verified, then this new block is deemed valid. The new public ledger with updated information is now deemed as the new consensus. Thus we have a cleverly-engineered consensus via a system that doesn’t rely on trust but rather on a ‘proof of work’. A natural question: why would anyone bother to mine for this random number? This is the part of the system that relies on human self-interest. For every verified number that is ‘mined’, the Bitcoin network allocates 12.5 bitcoin [~ $30,000] to the miner. When more people (as of 2015, nearly 100,000 merchants) accept bitcoin or other cryptocurrencies for goods and services, their value increases.

The real, and perhaps unanswerable, question is what is their true value— i.e., how many rupees is any given cryptocurrency worth? The real answer is: no one knows. Unlike fiat currencies, whose long-term relative values are driven by differentials in purchasing power, we do not have a good understanding of what determines the long-term relative value of these cryptocurrencies. But this has not stopped investors from betting on the increased acceptance of various versions of blockchain technology (Ethereum, SIA, Ripple, Litecoin etc) and its currency units.

Since 2014, the American tax authorities have treated cryptocurrencies as ‘property’ subject to appropriate capital gains tax rate. On April 1 2017, Japan has deemed bitcoin as a legitimate payment method; on July 1st, Australia will follow. Chinese authorities have aggressively stepped in, when needed, to ensure cryptocurrency exchanges function well. Over the past seven years, successive Indian governments have ignored cryptocurrencies. Finally, on April 12 2017, the Indian government constituted an inter-disciplinary committee to study regulatory frameworks for cryptocurrencies. It has sought public comments. However, prominent voices like the BJP parliamentarian Kirit Somaiyya have called for an outright ban citing some understandable (what happens to the monopoly of rupee in India as medium of exchange?) and many absurd fears (drugs, money laundering, Ponzi schemes).

What the Indian government ought to do instead is follow, learn, and innovate based on what China, South Korea, and Japan have done: enshrine minimum capital requirements, force segregation of customer accounts, and make potential criminal activity difficult. The Indian state can either help structure the growth of cryptocurrencies or drive the whole enterprise underground beyond its control. As a wise Finance Minister, quoting Victor Hugo, said during his 1991 budget speech: “no power on earth can stop an idea whose time has come”. []